Why banks should be wary of investing in mortgages

Banks that invested too much in mortgages in the 1920s were more likely to fail in the 1930s during the Great Depression—suggesting a strong connection between bank health and real estate investments today, says Natacha Postel-Vinay.  "Banks should think twice before loading up on [real estate loans] in good times." (Credit: Woodleywonderworks/Flickr)

Banks need to beware of over-investing in mortgages, a new study of 1920s Chicago banks warns. During the Great Depression, the city of Chicago had the highest urban bank failure rate in the United States.

“Chicago had been known by historians as undergoing a severe real estate boom and bust in the 1920s—but no one had actually undertaken to quantitatively test the link between this real estate boom and the bank failures,” says Natacha Postel-Vinay of the economics department at the University of Warwick.

“A majority of banks failed in Chicago, which makes it particularly important to study if one wants to find out about causes of bank failures generally.”

The study, published in the Journal of Economic History, comes the same month that Britain’s biggest building society, the Nationwide, announced it is increasing the maximum age of its mortgages to 85 and Barclays bank introduced a 100 percent mortgage—the first since the banking crisis.

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An analysis of bank balance sheet data from 1923 to 1933 shows that mortgages mattered for banks more from an illiquidity point of view rather than from a quality point of view. During the Great Depression banks didn’t report significant losses on these loans because their sizes were small relative to property prices. Nevertheless their lack of liquidity—due to long maturities—posed a significant problem when the banks faced a liquidity crisis.

In the 1920s, Chicago underwent a significant real estate boom and bust. The findings of the new paper suggest banks that invested too much in mortgages in the 1920s were more likely to fail in the 1930s Depression. This is significant to today’s banks as well, Postel-Vinay says.

By suggesting some continuity between the 1930s events and current ones, the paper supports the idea that there may be strong connections between bank health and real estate investments. Although in the recent crisis banks actually made losses on mortgages, their inherent lack of liquidity was also a source of weakness.

“Liquidity risk management matters,” Postel-Vinay says. “Although today real estate loans have gained in liquidity thanks to securitization, they are still fundamentally less liquid than other types of investment. Banks should think twice before loading up on those in good times.”

Source: University of Warwick